Are house prices really too high?

Houses feel expensive because an unusually large percentage of the payment is going toward principal amortization.

For the last few years, my monthly housing market reports rated most communities across Southern California highly, suggesting it’s a very good time to buy a house. Yet despite this dispassionate review of the math, most people who actually shop for a house feel like prices are way too high. Why is that?

Well, house prices are high. The federal reserve in conjunction with government officials reflated the housing bubble to restore collateral backing to lender’s bad loans. The housing bubble that peaked in 2005/2006 witnessed house prices 20 years ahead of their time. Reflating the housing bubble in 2016 still puts us 10 years ahead of where prices should be, which is one reason prices feel high.

Despite the high prices, the cost of ownership on a monthly-payment basis is not high — at least not historically high relative to rent, which is what largely determines affordability. But why does the math say one thing while our emotions say another?

At low mortgage interest rates, a larger amount of the payment is applied toward reducing the principal balance, and since I back this out of the cost of ownership calculation, very low mortgage rates reduce the cost of ownership more than if mortgage interest rates were higher.

The chart below illustrates this concept. I created a simple spreadsheet that calculated the payment on a fixed loan amount at various mortgage interest rates. Then I calculated how much of the initial payment applies toward principal. With those two numbers, I calculated the percentage of the payment that amortizes principal, which is the chart below.

As you can see, as mortgage interest rates drop, the percentage of the payment applied toward reducing principal rises very quickly. It’s not a straight-line relationship.

The percentage of a borrower’s income they can apply toward mortgage payments is generally limited to 31% of gross income. This cap applies whether rates are 3% or 13%. However, if the monthly payment were $1,000, at 3% nearly $400 is applied toward principal; at 13% only $20 is applied toward principal. Principal reduction is subtracted from the cost of ownership because it’s a forced savings, not an expense. Therefore, very low interest rates reduce homeownership costs even when the payment is the same.

Low house prices or low mortgage rates?

Whether low house prices or low interest rates are better is a matter of perspective. From a lender’s point of view today, low mortgage rates and high prices are better because they have so many underwater borrowers putting their capital at risk. Historically, lenders would prefer higher rates because interest is income, and they would rather make a higher rate of return by charging a higher interest rate, but the problem with underwater borrowers has shifted their preference.

From the perspective of taxing authorities, lower mortgage rates and higher prices are always more desirable. Municipalities get their revenues from property taxes, so they want to see land values as high as possible. Proposition 13 was supposed to prevent State and local governments from taxing people out of their homes, but instead, Proposition 13 prompts lawmakers to support policies that inflate house prices as much as possible to regain the lost tax revenue.

Most economists erroneously argue in favor of lower interest rates generally as a stimulus to the economy; however, low interest rates cut both ways because the interest cost to a borrower is income to a lender. The federal reserve’s zero interest-rate policy has crushed seniors living on fixed incomes. Their policy takes money away from seniors, which prevents them from spending this money on goods and services, and instead diverts this money to underwater homeowners who enjoy a debt-service subsidy. Where is the economic benefit in that?

So that opens the larger question about which is better, lower prices or lower interest rates? Both lower the monthly cost of ownership and result in more disposable income. Obviously, the banks prefer higher prices to recoup their capital from their bad bubble-era loans, so they are offering 3.5% interest rates to boost house prices. Most buyers would prefer lower prices, but since the banks make the rules which determine market prices, low interest rates and high prices prevail in the market.

From a homebuyers perspective, low rates or low prices depends on how they acquire the property. All-cash buyers would far prefer lower prices because they gain nothing from inexpensive debt they don’t use. From a financed buyer’s perspective, lower interest rates are better even if they pay higher prices.

If a financed buyer holds a property for 30 years and pays off the debt, how they financed the property doesn’t matter; however, if they sell the property before paying it off entirely, low mortgage rates are superior because they amortize faster. Assuming equal rates of appreciation during the holding period, a financed buyer using a low mortgage rate will accumulate more equity than a buyer who pays a higher mortgage interest rate; that’s the math. The key question is whether or not appreciation rates would be the same.

California lawmakers have introduced more than 130 bills this year that try to tackle the state’s housing affordability crisis.

Reams of statistics support the depth of the problem: California’s homeownership rate is at its lowest since World War II, a third of renters spend more than half of their income on housing costs and the state has nearly a quarter of the nation’s homeless residents — despite having 12% of the overall U.S. population.

William Fulton, director of the Kinder Institute for Urban Research at Rice University, said he has never seen such interest in housing in the three decades he’s been tracking the issue in California.

“It is the biggest issue in the state right now,” Fulton said.

Here’s a guide to some of the most significant housing bills up for debate in Sacramento and what they might do.

Financing low-income housing

For decades, federal and state politicians have subsidized homeowners, most prominently through giving them the ability to deduct interest from their home mortgages on their taxes.

But Assembly Bill 71 from Assemblyman David Chiu (D-San Francisco) aims to eliminate the state portion of that tax break for second, vacation homes and redirect the approximately $300 million it costs the state annually toward financing low-income housing instead.

Chiu’s bill is one of a number of efforts designed to boost funding for low-income projects. Senate Bill 2 from Sen. Toni Atkins (D-San Diego) and Senate Bill 3 from Sen. Jim Beall (D-San Jose) are the most prominent. Atkins’ bill would raise between $230 million and $260 million a year through a $75 fee on real estate transactions, such as mortgage refinances, except for home sales. Beall’s would put a $3-billion bond to fund low-income housing on the 2018 statewide ballot.

Assembly Constitutional Amendment 4 from Assemblywoman Cecilia Aguiar-Curry (D-Winters) would make it easier for local governments to raise taxes or pass bond measures to fund low-income housing. Her proposal would lower the margin needed to pass such measures from a two-thirds supermajority to 55%. This would also go on the 2018 ballot.

All these bills require two-thirds supermajority votes of the Legislature to pass, so they face high hurdles. And although most economists and housing experts believe more public dollars are needed to house the state’s poorest residents, greater subsidies won’t fix the problem. A report from the nonpartisan Legislative Analyst’s Office estimated that building affordable homes for the 1.7 million low-income households in California that currently spend half their salaries on housing would cost as much to finance each year as the state’s spending on Medi-Cal.

Removing obstacles from development

Last year, Gov. Jerry Brown failed in his bid to lessen local restrictions for developments that reserved units for low-income residents. His proposal by itself wouldn’t have created substantial new housing, but it would have profoundly changed the housing approval processes in Los Angeles, San Francisco and other cities that have multiple hurdles in place before new housing is approved.

While no one has replicated Brown’s effort so far, lawmakers have introduced narrower bills aimed at getting local governments to speed up their approval of housing, or preventing cities from blocking projects.

Senate Bill 35 from Sen. Scott Wiener (D-San Francisco) would force cities to streamline their permit processes if they’re not keeping up with state housing production goals. Assembly Bill 72 from Assemblyman Miguel Santiago (D-Los Angeles), Assembly Bill 678 from Assemblyman Raul Bocanegra (D-Pacoima) and Senate Bill 167 from Sen. Nancy Skinner (D-Berkeley) would strengthen and add money to enforce a state law that prohibits cities from denying low-income housing projects.

Assembly Bill 352, also from Santiago, would force cities to permit tiny apartments — as small as 150 square feet — as a way to house people more affordably. Many cities now require units to be larger.

Local governments have responded to this push with their own favored legislation, including Senate Bill 540 from Sen. Richard Roth (D-Riverside). This bill would allow cities to borrow money from the state to plan neighborhoods as zones for affordable housing. Once the planning is done, approval of such projects would be fast-tracked.

New tax breaks for renters and homebuyers

Two bills from Republican lawmakers would create or expand housing tax breaks. Assembly Bill 181 from Assemblyman Tom Lackey (R-Palmdale) would double the state tax credit that low- and middle-income renters receive to $240 for married couples and $120 for single filers. Assembly Bill 53 from Assemblyman Marc Steinorth (R-Rancho Cucamonga) would allow couples to save up to $20,000 tax free — $10,000 for individuals — toward the purchase of a principal residence.

Expanding rent-controlled, low-income rentals

Assemblyman Richard Bloom (D-Santa Monica), who has consistently been a sponsor of housing legislation, has introduced a host of bills this year. Three proposals, Assembly bills 1505, 1506 and 1521, would increase low-income housing by allowing cities to force developers to build more low-income rentals as part of their projects, expand rent control and protect aging affordable housing stock from going back on the market, respectively.

Based on a law in Massachusetts, Bloom’s Assembly Bill 1585 would introduce an out-of-court state appeals board for developers whose low-income housing was rejected.

Despite its failure, Brown’s housing legislation spurred a discussion that has raised the issue’s profile within the Capitol, Bloom said.

“I think it’s one of the most pressing issues that the state faces,” he said. “In addition to having statistically some of the worst poverty in the country, it’s exacerbated by the fact that housing prices are out of control.”

would double the state tax credit that low- and middle-income renters receive to $240 for married couples and $120 for single filers.

I guess its the thought that counts. And the fact lawmakers can take credit say they “doubled” the credit.

What a waste of money. No matter how low income you are $120 per year or $10 dollars a month is no more of an impact than a high five. It doesn’t even cover the extra taxes/fees and surcharges the state taxes attached the the various utilities needed to live in the rental. How about we do less giving money away and do less taking money away?

The problem would be solved if the state simply began preventing foreign nationals or non-U.S. residents from being able to purchase real estate. Suddenly the demand would lessen, and prices would naturally drop. So many people abroad, from China especially, are simply parking their money in homes as “investments” that sit empty most of the year. But we all know this will never happen because local tax coffers will not be as full with lower sale prices and property values.

Detroit was once known as a city where a working-class family could afford to own a home. Now it’s a city of renters.

Just 49 percent of Motor City households were homeowners in 2015, down from 55 percent in 2009 and the lowest percentage in more than 50 years. Detroit isn’t alone, of course: The rate of U.S. home ownership fell steadily for a decade as the foreclosure crisis turned millions of owners into renters and tight housing markets made it hard for renters to buy homes. Demographic shifts—millennials (finally) moving out of their parents basements, for instance, or a rising Hispanic population—further fed the renter pool.

Fifty-two of the 100 largest U.S. cities were majority-renter in 2015, according to U.S. Census Bureau data compiled for Bloomberg by real estate brokerage Redfin. Twenty-one of those cities have shifted to renter-domination since 2009. These include such hot housing markets as Denver and San Diego and lukewarm locales, such as Detroit and Baltimore, better known for vacant homes than residential development.

Sales of previously owned homes tumbled in February as the housing market remained choked by tight inventory.

Existing-home sales were at a 5.48 million seasonally adjusted annual rate last month, the National Association of Realtors said Wednesday. That was down 3.7% compared with January’s sales pace, which was the strongest in a decade.

The median forecast among economists surveyed by MarketWatch was for a 5.45 million pace.

Sales in February were still 5.4% higher compared with a year ago, but the supply situation has worsened. Inventory was 6.4% lower than in February 2016. Meanwhile, the median home price rose 7.7% compared with a year ago to $228,400.

At the current pace of sales, it would take 3.8 months to exhaust available homes for sale, the lowest in any February back to 1999.

Sales increased in only one region in February. They rose 1.3% in the South. The regional declines ranged from a 13.8% tumble in the Northeast to a 3.1% decline in the West. In the Midwest, sales were down 7.0%.

Across the country, properties spent a median 45 days on the market, down from 59 days a year ago. That’s evidence of strong interest in home buying, NAR Chief Economist Lawrence Yun said. Despite all the headwinds, demand remains “surprisingly resilient,” he added.

Still, in such a hot market, not everyone can compete. First-time buyers, who represent fresh demand in the market, made up 32% of all buyers, still well below the 40% share they’ve historically represented.

My concern with “affordability” right now is that a home that is deemed affordable needs about $50-100k in renovations to make it livable. So to me a lower price with a higher interest rate gives me more bargaining power and cash left over to do the much needed renovations. I see people buying really high and wonder when the roof leaks what happens….It seem like we’ll have a lot of people scraping by in nearly million dollar homes which is insane to me.